Key Inflationary Manifestations

It was another week of acutely unsettled financial markets. Despite considerable
volatility, the Dow ended the week down 1.5% and the S&P500 about 1%. The
Utilities dipped 1%. The Transports, Morgan Stanley Consumer, and Morgan Stanley
Cyclical indices declined 2%. The small cap Russell 2000 dipped 1%, while the
S&P400 Mid-cap index slipped less than 1%. The technology stocks were mixed.
The NASDAQ100, Morgan Stanley High Tech, and The Street.com Internet indices
declined 1%. But the Semiconductors added 2% and the NASDAQ Telecommunications
index gained 3% (y-t-d gain up to 8%). The Biotech index declined 2%. The Securities
Broker/Dealer index ended the week unchanged, while the banks lost about 1%.
With bullion down $1.80, the HUI Gold index declined 2%.

The Credit market seemed to go into "melt-up" mode this week, which
will surely pump additional fuel into the mortgage finance Bubble. Two-year
Treasury yields dropped 12 basis points to 1.48%, with five-year yields sinking
18 basis points to 2.66%. Ten-year Treasuries enjoyed their strongest weekly
gain this year, with yields dropping 20 basis points to 3.69%. The long-bond
saw its yield drop 17 basis points to 4.67%. Benchmark agency and mortgage-backs
performed well, with yields sinking between 17 and 20 basis points. The spread
on Fannie's 5 3/8 2011 note was unchanged at 29, while the 10-year dollar swap
spread widened 1.5 to 42. Corporate spreads widened moderately. Both the dollar
and the CRB index declined slightly. With stockpiles at 20-month lows ("strong
Asian demand"), Nickel prices are at the highest level since June 2000.
Propane traded to the highest level "in at least 31 years." Crude
oil traded to 12-year highs this week. March Heating Oil traded above $1.15
gallon, the highest since heating oil futures began trading on the NY Merc
back in 1978.

February 26 - Bloomberg: "Copper prices rose to a 21-month high on signs
of strengthening demand from China, which is vying with the U.S. to be the
world's biggest user of the metal increased demand from an expanding Chinese
economy has contributed to a 14 percent rise in copper prices this year. Chinese
demand will rise 12 percent this year to 2.85 million metric tons… 'There
is strong consumption coming out of the Far East,' said James Koppel, a managing
director at SG Commodities Group… 'If China continues its buying activity,
it will be enough to offset some marginal increase, or decrease, in consumption
in the U.S.'

This week saw continued robust debt issuance. Wells Fargo sold $1.5 billion
of floating rate notes. JC Penney raised its deal to $600 million from $350
million. Healthcare Properties sold $200 million. El Paso Corp. received a
$1 billion loan. A unit of Williams Company raised $175 million in the junk
bond market. Occidental Petroleum raised $300 million, ANR Pipeline $300 million,
Southern Natural Gas $400 million, and Chesapeake Energy $300 million (inflation
in the energy sector "fueling" Credit creation?). In regard to the
demand for the company's $250 million 10-year notes, Potash Corp.'s CEO was
quoted by Bloomberg: "I'm told it was excellent, substantially over-subscribed,
north of $1 billion." "Sales the past two months by more than 160
companies and sovereign borrowers… have brought year-to-date issuance
in the U.S. to more than $129 billion, some 27 percent higher than in the same
period in 2002, according to Bloomberg data." And according to Merrill
Lynch, Investment-grade debt returned 1.7% this month (up 6.74% since October
10th). Junk bonds earned 1% during February and are up 4% y-t-d.
Junk bond funds were said to have received inflows of $1.5 billion last week,
not far from the record $1.6 billion of inflows received in August (from AMG).
Year-to-date junk issuance of $20 billion compares to last year's comparable
$11 billion.

February 28 - Bloomberg: "Tax-free debt yields close to 35-year lows
and New Jersey's $1.65 billion tobacco bond sale made for the largest February
ever for municipal bond sales, the second consecutive record month this year.
Municipal bonds worth $26.84 billion were sold this month, according to the
Bond Buyer newspaper, that's up 28 percent from last year and eclipses the
previous February record of $24.55 billion in 1998. January sales set a
record of $23.39 billion in bonds for public purposes. Last year, public issuers
sold $357 billion in bonds, the most ever."

February 26 - Dow Jones (Stan Rosenberg): "It took record long-term yields
Wednesday to sell $1.65 billion of tax-exempt bonds issued by New Jersey's
Tobacco Settlement Financing Corporation. The bonds, backed by revenues from
a settlement between 46 states and the four largest cigarette manufacturers,
represented the largest offering among several major municipal bond issues
priced. Those issues totaled about $2.8 billion… The New Jersey issue
offered investors tax-exempt returns of up to 7.10% for bonds coming
due in 2041, as well as 7.05% yields for securities maturing in 2039 and 2043, both
the loftiest yields ever for securities backed by the 1998 pact… The
market has been saturated with tobacco offerings, especially since budget-strapped
states have turned to the use of non-recurring, or 'one-shot', revenue sources
as short-term solutions to long-term problems. New Jersey is facing a $5
billion budget deficit for the fiscal year beginning July 1. All tobacco bonds,
however, are backed by the same settlement and are viewed by professionals
as essentially the same security… The result has been higher yields with
each offering."

Broad money supply (M3) expanded $20.5 billion last week and is up $100.5
billion in five weeks. Since October (19 weeks), "money" has surged
$254.3 billion, or 8.4% annualized. Since April (44 weeks), money supply has
increased $519.7 billion, or 7.6% annualized. Last week by money supply component,
Currency was up $1.4 billion, Demand Deposits $15.5 billion, and Savings Deposits
$15.1 billion ($52.5 in two weeks). Savings Deposits are now up 20% y-o-y to
$2.863 Trillion. Last week, Small Denominated Deposits declined $1.4 billion
and Retail Money Fund deposits were up $0.8. Institutional Money Fund deposits
added $3.2 billion, while Large Denominated Deposits were down $9.3 billion.
Repurchase Agreements were down $0.9 billion and Eurodollars declined $3.1
billion. Elsewhere, Total Bank Assets jumped $41.4 billion last week. Securities
holdings added $13.6 billion, with three-week gains of $58.2 billion. Loans
and Leases declined $0.7 billion, with Commercial and Industrial loans up $2.4
billion and Real Estate loans declining $$9.9 billion. Over the past 52 weeks,
Total Bank Assets were up 10.2% to $7.03 Trillion. Real Estate loans jumped
$16.8% to almost $2.1 Trillion, while Commercial and Industrial (C&I) loans
declined 6.6% to about $1 Trillion. Since May (41 weeks), Real Estate loans
have expanded at a 20% rate, while C&I loans have declined at an 8% annualized
rate.

February 25 - Bloomberg: "Debt secured by credit card, airplane leases
and other types of payments had a record amount of downgrades and defaults
in 2002, as a slow economy hurt the ability of borrowers to make payments,
according to Standard & Poor's. Downgrades of so-called asset-backed
debt more than tripled to 356 from 2003, while the number of issues upgraded
declined by more than half to 39, S&P said. Defaults rose to 58 from
12 in the previous year."

February 25 - Moody's: "While fewer corporate issuers defaulted on rated
bonds in 2002, the total dollar volume of defaulted debt soared to over $163
billion, up from $106 billion in 2001, Moody's Investors Service reported today
in its 16th annual study of global defaults and ratings performance."

February 25 - Bloomberg: "Spiegel Inc., the owner of Eddie Bauer stores
and the Spiegel catalog, was ordered by the Office of the Comptroller of the
Currency to start liquidating its credit-card business. The company won't meet
requirements on two of the securities backed by the bankcard debt and is in
danger of defaulting on a third that is backed by the credit-card receivables,
according to a regulatory filing. The cards are issued by Spiegel's First Consumers
National Bank division... About 41 percent of its sales in 2001 were made with
its credit cards. Spiegel agreed last year to either sell or liquidate the
bankcard portfolio by April 30. Spiegel may not be able to repay the principle
on the asset-backed securities that it is required liquidate if it doesn't
meet the targets and isn't allowed to borrow more, it said in the Securities
and Exchange Commission filing."

Today from St. Louis Federal Reserve President William Poole: "This is
the most sound, lowest risk place in the world to place a buck… The Fed
stands ready to respond vigorously and dramatically to upsets in the market,
whatever they might be."

Keeping in mind our theme that economic imbalances are today a Key Credit
Inflation Manifestation, we discern only greater regional disparities going
forward. The Chicago Purchasing Manager index came in at a stronger-than-expected
54.9. This index was a 46.1 back in November and was in the upper-thirties
during the first half of 2001. Prices Paid increased 0.7 to 54.9 and New Orders
added one to 59. Production remains quite strong at 62.4. This report is consistent
with the much stronger-than-expected 3.3% increase in Durable Goods Orders.
But it's a different story in New York. The February New York City Purchasing
Management business activity index sank 17.4 point to 34.5, the weakest reading
in 13 months. Curiously, the Non-manufacturing index sank 18.5 points to 33,
while the Manufacturing index declined 8.1 points to 47.6. Prices Paid jumped
six points to 50 (up nine points in two months). The Milwaukee index added
three to 53, the strongest reading since October.

In our attempt to monitor global demand for U.S. securities, we pay close
attention to the monthly Foreign Purchases and Sales of U.S. Securities report
from the Treasury Department. We see December foreign-sourced purchases of
$37.7 billion (down from November's $69.7 billion). Demand for Agency Securities
remains strong, accounting for 43% of December purchases. This compares
to 6% for U.S. Stocks and 35% for U.S. Corporate Bonds and 38% Treasuries.
Agency purchases were also the largest category for the year, with acquisitions
of about $190 billion up 16% y-o-y. It is worth noting that Agencies and Treasuries
combined for 52% of total foreign net purchases during 2002, up from the previous
year's 36%. During the year, U.S. stocks dropped from 23% to 9% and U.S. Corporate
Bonds from 45% to 34%. This data is consistent with U.S. financial sector.
Lenders remain eager to finance mortgage and government borrowings, with relatively
little interest in directing finance to sound investment (outside of the now
Bubbling energy sector!). It is also worth noting that 64% of the net acquisition
and disposition of Agency securities internationally during December was in
the Caribbean.

Existing Home Sales were reported at a stronger-than-expected and record annualized
rate of 6.09 million. To put this sales level into perspective, January sales
were more than double the level from the dark days of the early nineties recession.
January (annualized) sales were also up 40% from the pre-Bubble January 1997
level. And with both sales and average prices up 40%, total Calculated Transaction
Value has almost doubled in six years to $1.24 Trillion (4.34 million units
at $145,800 versus 6.09 million units at $204,000). January's Calculated Transaction
Value is up 8% y-o-y and 34% over two years. Conversely, New Home Sales were
reported at a disappointing 914,000 pace. This was the weakest reading in a
year, although sales were up 5.1% y-o-y. Notably, the inventory of New Homes
continues to "build," increasing 7,000 for the month to 346,000 units.
This is the highest inventory since March 2001. Looking at the dollar value
of inventories, we see a y-o-y increase of 12.4% and a 30% increase in less
than two years.

From the California Association of Realtors: "The robust momentum we
witnessed in the California housing market throughout 2002 continued in January.
The Median price of a home has increased by double digits for the last 14 months
and shows no signs of abatement as we approach the traditional spring selling
season." There are two distinct California Housing Bubble stories.
First, even the most inflated markets are apparently not giving up any air.
Year-over-year, median prices are up 4% in Santa Clara, 6.4% in San Francisco,
7.5% in the Monterey Region, and 10.6% in Santa Barbara County. And while previous
Bubble prices are sustained, the lower spectrums gain full Bubble status. Year-over-year,
the Central Valley is up 22.2%, High Desert 17.7%, Los Angeles 18%, and Riverside/San
Bernardino 20.9%. Prices are up 26.9% in San Diego, 25.6% in Sacramento, 21.9%
in Orange County and 27.9% in North Santa Barbara County. For the state as
a whole, median prices are up $49,660, or 17.3%, to $336,740. This provides
much inflated "equity" to extract during refinance or through a home
equity loan, and all the ingredients are in place for an interesting spring
and summer for the Great California Housing Bubble.

The mortgage refi application index jumped 10% to the highest level since
mid-November, and remain more than double the year ago level. Perhaps weather
related, but it is worth noting the Purchase applications dropped 7.5% to the
lowest level since February 2002, and is now slightly below the year ago level.
There were 28,724 bankruptcy filings during the holiday-shortened week.

After four months of the fiscal year, federal finances could not appear more
dismal. Fiscal year-to-date revenues are down a striking 8.1%. Individual Income
Tax receipts have declined 9.4% to $306.5 billion, while Corporate Income Tax
receipts are down 47% to $34.2 billion. Social Insurance and Retirement receipts
are up 4.5% to $167.2 billion. At the same time, fiscal y-t-d Outlays have
jumped 7.8%. With receipts and outlays in anomalous divergence, last year's
$98 billion y-t-d surplus has evaporated to this year's $8 billion. By largest
Outlay category, Health and Human Services expenditures are up 12.6% to $170
billion, Social Security Administration up 6.6% to $168.4 billion, Defense
up 19% to $123.4 billion, Agriculture up 4.5% to $33.6 billion, Labor up 27.2%
to $23.2 billion, and Veterans Affairs up 22% to $20.3 billion. Noteworthy
increases from smaller departments include Emergency Management up 18%, Housing
and Urban Development 10.2%, and Civil Defense up 14.6%. Year-to-date Interest
payments on Treasury Debt have declined 2% to $131.4 billion.

In last week's Bulletin I made use of a thermostat analogy in describing how
the seductive ease of managing Credit inflation can not only suddenly vanish,
but quickly spiral out of control. "Then one day, somehow, it's at the
same time too hot and too cold; then it's boiling hot in one room and freezing
in the next. The small adjustments that always did the trick before have become
impotent. Major alterations only exacerbate the extremes; and then things fall
into disarray and beyond control." To expand and clarify this analysis,
over many years we watched the awe-inspiring power of slight changes in Fed
interest rates (or hints of minor adjustments) evolve to the point where even
an historic collapse in rates garners only a tepid response from the real economy
(and has had no discernable impact on the stock market). During the boom, just
the thought of a Fed rate cut would spur a speculative melee in the financial
markets and almost instantaneously augment Credit Availability. This was the
marvel of the contemporary securities-based Credit system.

But nowadays, after years of Credit and Speculative Abuse, distorted financial
and economic systems respond to stimuli much differently. First of all, the
previously effective small rate cuts (minor adjustments to the thermostat)
no longer incite heightened speculative response (after years of over-stimulation).
There is, then, little marginal impact on general Credit Availability. Moreover,
major rate cuts (big adjustments to the thermostat) today only tend to exacerbate
the inflationary bias for sectors already affected by excess Credit Availability
("Liquidity Loves Inflation" - with thermostat adjustments making
the hot rooms only steamier). We see such dynamics at work today throughout
the manic mortgage finance super-sector, impacting home values as well as agency
and mortgage-backed securities prices. Additionally, mortgage Bubble induced
trade deficits are increasingly recycled directly back to agency and mortgage-backed
securities in the circular Bubble of Structured Finance.

At the same time, other sectors suffering various degrees of post-Bubble depression
(such as the stock market, technology industry or, perhaps, even the goods
sector) remain generally numb ("deflationary" bias) to even enormous
systemic Credit and speculative stimulus. Much to the detriment of the already
distorted system, the amount of Credit necessary to stimulate these despondent
sectors exacerbates and tends to grossly disturb the manic sectors. If the
operator of the thermostat is fixated only on the cold rooms, there's going
to be some awfully sweltering rooms and a very heavy cost to keep the home
heated.

After years of Credit inflation and its cumulative distorting affects, enormous
and unrelenting Credit excess is required to generally stimulate (stabilize)
the maladjusted U.S. economy. Some inflating sectors (the California Housing
Bubble or healthcare, for example) ripen into absolute Credit Gluttons, much
at the expense of other regions and sectors. Other fledgling inflation beneficiaries
(such as the energy sector) spring to life with increasingly crazed appetites
for Credit (again at the expense of the post-Bubble depressed). Manifestly,
the amount of gross excess necessary to stimulate the imbalanced and generally
despondent real economy provides jet fuel to the inflating speculative Bubble
in the U.S. Credit market. There is no way around the fact that, at this stage
and going forward, Credit inflation will spread quite unevenly through the
real economy sphere. It will also surely further exacerbate dangerous excesses
and instability throughout the financial sphere. We view Credit Inflation Manifestations
in the financial sphere as The Big Unexplored Story.

There is also the critical issue of our authorities (and the U.S. financial
sector) striving to sustain inflated boom-time consumer demand, with resulting
over-consumption and ballooning trade deficits. Today, an enormous amount of
Credit inflation is "exported." We see this as a case of further
risky expansion of the U.S. financial sector that provides little benefit to
the faltering Bubble economy. That the marginal consumer borrower is today
a very weak Credit ensures only poorer U.S. financial asset quality and eventual
impairment. Less conspicuous but no less important, we also see this Credit
inflation funneling additional finance to the irrepressible global Leveraged
Speculating Community. Surging (and hyper-volatile) energy, Gold, and general
commodity prices are an obvious Manifestation.

This "funneling" was for some time seductively agreeable, as speculative
flows were immediately and painlessly "recycled" back to the inflating
U.S. equity and bond Bubbles. Credit surged, the markets rose, the economy
boomed and the dollar excelled. Self-reinforcing speculative flows were largely
responsible for The Grand Illusion of Immortal King Dollar, impervious to even
gross Credit excess and severe economic impairment. But, in the end, this Illusion
was dangerous and self-defeating - speculation-induced market distortions coming
home to roost. Going forward, we expect the ballooning "export" component
of U.S. Credit inflation to provide increasingly unwieldy Inflationary Manifestations.

It is worth repeating that I view the demise of King Dollar as a critical
inflection point in financial and economic history. Following a pattern similar
to other major bull markets, it is ending in one final wild and destructive
period of Credit and speculative "blow-off" excess. Resulting U.S.
financial and economic sector impairment will linger for years. At the very
minimum, the faltering dollar marks a critical juncture for the nature of Credit
Inflation consequences. Namely, it ushers in an environment of only greater
financial market and economic instability, as well as erratic prices for things
real and financial, at home and globally. And with one eye on the energy markets,
we see support for the notion that a faltering currency sets in motion self-reinforcing
(Credit-induced) Inflation dynamics.

In a week that saw a 30% one-day spike in natural gas prices and crude surge
to 12-year highs, it is fair to say that commodity prices are garnering increased
speculative interest ("animal spirits"). We see this as further confirmation
of a sea change in inflation psychology, for commodities, currencies, and other
things non-dollar. Not only will the speculators be keen to rising prices,
evolving market psychology will alter behavior in the real economy. We have
read recent reports that the Chinese are considering establishing a petroleum
reserve, as well as being aggressive purchasers of cotton and other commodities.
Global producers are now keen to the risk of depleted inventories of fuel and
basic commodities. Gold producers and speculators will now think twice before
shorting the shiny metal. Many will come to see the value of holding real gold,
crude oil, natural gas, cotton, platinum, and such, as opposed to futures contracts
or derivative hedging instruments. We would expect only heightened interest
- speculative and investment - in acquiring things real; and the less elastic
the supply the more appealing. As such, we suspect the relative allure of holding
(too easily inflated) things financial, especially claims denominated in dollars,
will only dim. With such profound changes in market psychology in the works,
we should expect great uncertainty and instability, especially following history's
greatest Bubble in financial assets.

We must then ponder what this all means for the "fabricators" of
and "intermediaries" for the ever-inflating mountain of U.S. financial
assets. As often discussed, we have reached the stage where it requires massive
and unrelenting Credit excess to maintain the dangerous U.S. financial and
economic Bubbles. We also appreciate that "Structured Finance" has
come, by necessity, to dominate the Credit creation process. Only this mechanism
could today possibly transform the massive quantities of risky loans into highly-rated
securities palatable to the marketplace. Structured Finance has won command
of the U.S. "money" and Credit system by default - by Bubble necessity
- with unknowable but quite disconcerting consequences.

Indeed, a paradoxical and problematic environment for "Structured Finance," hence
the U.S. financial sector and dollar, is now coming into clearer focus. Structured
finance exists based upon an immutable reliance on historical data, statistical
analysis, sophisticated modeling, and the rather predictable forecasts that
the future will be much like the past. Uncertainly is basically taken out of
the equation. Yet, presuming the arrival of an historic financial and economic
inflection point, we see the past as providing only comforting deceptions for
an especially uncertain and problematic future. Importantly, the unending Credit
excess now required to keep the U.S. financial and economic wheels from seizing
up ensures atypical and especially unpredictable outcomes. Uncertainty now
reigns supreme. We wouldn't want to be a writer of Credit protection these
days…

Similar to the recent spikes in California and New York home values, this
week's surge in energy prices should be recognized as evidence we have commenced
a period of even greater financial and economic instability. Furthermore, these
types of extreme price gyrations are anathema to writers of derivative protection,
the Credit insurers, and financial risk intermediaries generally - the very
parties directly responsible for fueling the destabilizing Bubble. While not
especially unambiguous, Structured Finance and general financial system disarray
have become A Key Contemporary Inflationary Manifestation.

It remains my view that Structured Finance and the dollar are now irreversibly
linked to each other. They are both hostage to the Credit Bubble. Granted,
the dollar has suffered a meaningful decline with little appreciable impact
on the U.S. financial sector or securities markets. Interest rates have remained
in steady decline, spreads have narrowed sharply, and liquidity flows (overly)
abundant. Importantly, inflating prices have thus far considerably offset currency
losses for our foreign creditors. But we see all of this as a Bubble anomaly
and part of the same issue - and key to an amazing financial puzzle. My analysis
leads me to believe that it is actually the massive Credit creation husbanded
by Structured Finance that is largely responsible for the flood of liquidity
continuing to inflate debt securities prices. It is thus an enormous expansion
of financial sector liabilities (financial Credit) fueling the self-reinforcing
Ultimate Bubble throughout the U.S. Credit market.

But what would it take for "virtuous cycle" to become "vicious
spiral"? Well, we think the combination of a faltering dollar, rising
yields and widening spreads would not be well-received by our foreign-sourced
financers. With this in mind, we suspect that this gigantic Bubble is today
acutely vulnerable to any reduction in U.S. financial sector expansion/liquidity
creation. Yet, the amount of unrelenting dollar financial asset Inflation now
required to sustain the Bubble is today increasingly fomenting a change in
market perceptions - stoking inflationary psychology for things non-dollar.
There will come a day when there will be a major adjustment in U.S. debt securities
values. This is a major problem- the proverbial Catch22 - that leads us to
believe that complacency with respect to the dollar is unjustified.

Today, one need look only to unparalleled mortgage Credit growth for the major
source of liquidity creation. This is problematic on many levels. It is simply
incredible that the American household sector is taking on record amounts of
debt at this very late stage of the Bubble. For the real economy this fosters
only greater maladjustment; for the financial sector, only weaker debt structures
and acute financial fragility. While the Mortgage Finance Bubble did sustain
the system through the bursting of the Technology and stock market Bubbles,
it has absolutely buried the consumer sector in debt. And despite an elongated
mortgage refi boom, we see increased evidence of cracks in the foundation of
consumer finance.

Structured Finance single-handedly transformed subprime (credit cards, auto,
mortgages, motor cycles, boats, facelifts, etc.) from an odd peripheral player
to the powerful Credit mechanism financing the marginal buyer sustaining the
vulnerable U.S. Bubble economy. And despite the predictable serious troubles
now asphyxiating subprime Credit cards and auto finance, reckless excess runs
out of control in subprime mortgage lending. That the major Credit insurers
have significant exposure to subprime is today a developing issue. That subprime
mortgage excess is sowing the seeds of its own destruction is also not in doubt.
An unparalleled consumer borrowing binge may have mitigated the corporate debt
crisis, but there will be no similar expedient to rescue the over-borrowed
U.S. consumer. Inflationary manifestations such as surging fuel, healthcare
and insurance costs will only play a greater role in hastening unfolding consumer
debt problems. General financial and economic instability will also be increasingly
debilitating for the household sector. And we do expect the eventual piercing
of the consumer debt Bubble to severely impair the Structured Finance Monetary
Regime, leading to the "vicious spiral" of faltering Credit availability,
reduced Credit creation, faltering systemic liquidity, and perhaps a problematic
run on dollar assets. How quickly the market discounts this eventuality is
today unknown.

Importantly, it is our view that consumer finance has supplanted corporate
finance as the weakest link in the financial daisy chain. Structured Finance
is now clearly in the crosshairs, and it difficult to envision a scenario where
the dollar does not face severe problems in the not too distant future. Psychology
is changing and so are Key Inflationary Manifestations. Instability Abounds.